Arbitrage can be defined as the strategy of taking advantage of price differences

of the same asset in different markets to make a profit. Arbitrage is the process
of simultaneous buying and selling of an asset from different platforms,
exchanges or locations to cash in on the price difference (usually small in
percentage terms). While getting into an arbitrage trade, the quantity of the
underlying asset bought and sold should be the same. Only the price difference
is captured as the net pay-off from the trade. The pay-off should be large enough
to cover the costs involved in executing the trades (i.e. transaction costs). Else,
it won’t make sense for the trader to initiate the trade in the first place.

(Suppose an asset, gold, is quoted at Rs 27,000 per 10 gm in the Delhi bullion

market and at Rs 27,500 in the Mumbai bullion market. A trader may buy 10 gm
of gold in Delhi and sell it in Mumbai, making a profit of Rs 500 (Rs 27,500 -
Rs 27,000). However, this trade will be profitable only if the cost of transactions
is less than Rs 500 per 10 gm of gold.

In the above example, assuming that the total transaction cost, of executing the
trades and physical delivery of gold, is Rs 200 for 10gm, then the net profit for
the trader would reduce to Rs 300.)

Arbitrage describes the act of buying a security in one market and

simultaneously selling it in another market at a higher price, thereby enabling
investors to profit from the temporary difference in cost per share. The
arbitrage strategy can be used in many markets, including those for trading
stocks and those for currency trading.

Definition of the Modigliani-Miller Theorem

 The theory suggests that a company’s capital structure and the average
cost of capital does not have an impact on its overall value.
 The company’s value is impacted by its operating income or by
the present value of the company’s future earnings.
 It doesn’t matter whether the company raises capital by borrowing
money, issuing new shares, or by reinvesting profits in daily operations.
Interpreting the Modigliani-Miller Theorem

 The basic theory assumes a perfectly efficient market, without issues of

taxes and other financial costs.
 The first proposition of the M&M says that the value of leveraged firms
(capital structure with a mix of debt and equity) and unleveraged firms
(capital structure with only equity) are the same. If not, there would be an
arbitrage opportunity and will eventually become equal.
o Arbitrage is the opportunity to earn profit through market
fluctuations with the common practice of buying at a lower price to
sell at a higher price immediately.

V(unlevered) = V(levered)
(Where V(unlevered) = company with no debt financing and V(levered) =
company with some debt financing)

 Investors that purchase shares of a leveraged firm, one with a mix of debt
and equity financing, would receive the same profits as when buying
shares of an unleveraged firm, which is financed entirely by equity.
 The second proposition states under the theory with no taxes suggests that
the cost of equity of a company is proportional to the company’s debt
level.
o When debts increase in a company, there are more chances of
going default.
o Investors demand a greater return on their investments with the
increase in risk.

re = ra + D/E (ra – rd)

(Where re = cost of levered equity, ra = cost of unlevered equity, rd = cost of
debt, D/E = ratio of debt to equity)

The Modigliani-Miller Theorem in Practice

 In the real world, companies are not free from the obligation to pay taxes
and other transactional costs.
 Considering this, the Modigliani-Miller Theorem has been revised to
accommodate the real-world scenarios better.
 The first proposition under this revised theorem suggests that the value of
a levered company is greater than the value of an unlevered company,
with the tax-deductible interest expense.

V(levered) = V(unlevered) + (T * D)
(Where V(unlevered) = company with no debt financing, V(levered) = company
with some debt financing, T = tax rate, and D = amount of debt)

 The second proposition considers the relationship between the cost of

equity and the level of debt, as risks are still involved.
 The formula for WACC used under this proposition states that when the
level of debt increases, there is a guaranteed drop in the WACC.
 With this, there is an optimal capital structure when the debt level is
100%.

re = ra + D/E (ra – rd)(1 – T)

(Where re = cost of levered equity, ra = cost of unlevered equity, rd = cost of
debt, D/E = ratio of debt to equity, and T = tax rate)

 Assumptions made here include taxations on earnings after interest, the

inexistence of transactional costs, and the same borrowing rate for
individuals and firms.